With RDR in mind, the smart money is on the low-cost passive world taking a greater chunk of retail business, but the emergence of so-called smart beta funds could muddy the waters.
Smart beta is gaining traction as a new route in to the passive space, but defining what it actually means is not easy. If beta takes into account the risk of an investment in comparison to the market as a whole, smart beta implies either adding or taking away part of the market to improve risk/return, thus bringing it more in line with active investing.
Robert Arnott, founder of California-based Research Affiliates is attributed as being a forefather of the smart beta concept, with the Research Affiliates Fundamental Index (RAFI) methodology a pioneer in the idea of selecting and weighting stocks by company size, as opposed to market capitalisation.
The aim is to capture the benefits of passive investing with less exposure to pricing errors and fads.
Paris-based Tobam is one of the newer players to field smart beta products, through its Anti-Benchmark concept.
Neutral vs biased
Founder and president, Yves Choueifaty, says the key conflict is not between the passive and active worlds, but more between what he sees as neutral and biased. In a nutshell, he holds that the traditional market-cap weighted indices that we are used to cannot be seen as neutral in their risk allocation.
“The indices are biased because they are passive, and in order to stay neutral you need to be active and not let prices drive risk allocation,” he says.
Choueifaty points to the historical performance of the S&P 500 over the past 45 years, where momentum has seen the index build unwanted biases to asset classes (energy, technology, financials) at the worst possible times.
He adds: “When you always build your portfolio in a completely irrational way by always overweighting what is over-valued and underweighting what is under-valued, the cost of that is extremely expensive. In fact, the most expensive way to invest in equity markets is probably to buy a market-cap weighted benchmark.”
Peter Sleep, senior portfolio manager at Seven Investment Management, is a supporter of smart beta products, arguing that while some may invest in a traditional ETF to capture the equity risk premium, it is wrong to assume that you are perfectly diversified.
“When you look at, say, the FTSE 100, you are not perfectly diversified as you are probably over investing in oil companies – Shell, BP, Tullow, and so on. – and resource stocks generally,” he says.
“In every index there are biases and inefficiencies, and by investing in some of the less representative indices you are actually taking some active bets yourself, and you are not possibly going to capture the full equity risk premium that is available.”
The various equal-weighted funds (both ETFs and Oeics) are probably the most easily understood of smart beta products, though there other ways to approach the concept.
Another Paris-based asset manager, Ossiam, is a frontrunner in minimum variance ETFs. In simple terms, the objective of these is to reduce volatility based on forecasts of future risks associated with different stock combinations.
Ossiam’s Minimum Variance funds have maximum exposures to a single stock at 4.5% and sectors at 20% of the value of the portfolio.
“There has been a long-lasting belief that the market-cap index was efficient, but when you back test these kinds of [smart beta] strategies, not only do you significantly reduce the risk, but you also outperform in very different market conditions,” says Antoine Moreau, Ossiam’s deputy chief investment officer.
“We are not saying that during any period of time we will outperform, but we are proposing that the behaviour of the product can be easily understood.”
Developed market equities are no doubt easily understood and accessed by retail investors, but can smart beta be applied to other more arcane asset classes?
Moreau thinks so, and in March, Ossiam launched its Emerging Markets Minimum Variance ETF. This selects among the 400 most liquid stocks from the S&P IFCI Index, a market capitalisation index that tracks the performance of over 1,800 stocks in 20 emerging countries.
“What is very interesting about this methodology is that in all the universes you arrive at the same conclusions – the same magnitude for the risk reduction and the same expected outperformance over the long term,” claims Moreau.
“The difference, when you come to wider investment universes such as global emerging markets, is that you need to put in some constraints in order to avoid having too much concentration on one country, because you want your final minimum variance index to be quite representative of the global emerging markets economy.”
Interestingly, Ossiam is also in the early stages of developing a smart beta product for sovereign bonds.
Adds Moreau: “When you see what the current debt crisis implies, it is understandable that you may be better off constructing an index differently, and that weighting proportionally to the amount of debt a country has is not the best way.”
It is clear that asset managers see great opportunities to expand the smart beta concept into new products, and with different structures to suit different investors.
Oeics and ETFs are regularly available, and there is willingness for flexibility – Ossiam chose to use physical replication for its FTSE 100 Minimum Variance ETF in part because of UK investors’ apparent distrust of synthetic products. Of course, smart beta has its critics, not least because of the ‘smart’ label which implies superiority to any other products.
For Jeff Molitor, chief investment officer, Europe, at Vanguard Asset Management, it is nothing but a “marketing game” with groups too focused on backwards-looking data.
“All of these approaches are really just limiting to a subset of the broader market; you are either under-emphasising some part of the market, and by definition over-emphasising another part,” he remarks.
“So much of what people are talking about as smart beta is really a form of active management. It comes back to the idea that if you can be smarter than the consensus view of investors, then you are smarter than the market, you have an approach that is going to do better, and the market is not going to arbitrage away this wonderful discovery you have found.”
Molitor believes equally-weighted indices are not always investable, in that it is often impractical to buy small stocks at the same level as larger stocks.
“Sometimes a lot of these portfolios are solutions in search of a problem,” he adds.
Fundamental Tracker Investment Management has fielded its dividend-focused Munro Fund since 2007, and managing director Robert Davies admits that it was only recently that smart beta became the accepted mantle. Before then, the fund was labelled internally as a ‘tracker with a twist’ or a ‘hybrid fund, halfway between passive and active’.
In response to the accusation of being backward looking, Davies says his fund’s approach is to use forecasts rather than historic data in determining allocation.
“We use forecasts, and are not looking at historic data, because as far as we are concerned what happened last year is ancient history in stock market terms,” he explains.
“We might be criticised for using forecasts, which are subjective, but we take consensus forecasts – for example, with Vodafone, we have 24 analysts taking in next years’ data.”
Using the total pot
Outlining the process further, he adds: “If Vodafone is forecast to pay out £7bn in dividends next year, that makes up around 9% of the total of £81bn that the whole market is forecast to pay out.
“So Vodafone’s weight in our portfolio is around 9%, whereas the market weight cap of Vodafone is around 5%. It is a tracker, but we do not use the market-cap weight measure, instead we use the total pot.”
It is clear that smart beta still has plenty of scope for growth, and new products are being launched on a weekly basis.
How they might fit within a retail investor’s portfolio is another matter entirely, though marketeers are keen to emphasise their different performance to traditional passive funds – even if they do not necessarily beat the beta over all periods.